IRS Practice and Procedure News Briefs for May 2021

C CORPORATION DISGUISED DIVIDENDS – Aspro, Inc. v. Commissioner, T.C. Memo. 2021-8 (2021)

Why this Case is Important: Because W-2 compensation is deductible to corporations but dividends are not, it generally is less expensive from a tax perspective for C corporation shareholders to receive payments from their corporation in the form of compensation rather than dividends, even taking into account the employment taxes that must be paid. However, corporations are not free to characterize payments as compensation or dividends at their sole discretion, as this case demonstrates.

Facts: Aspro, Inc. was a C corporation in the asphalt paving business. Its stock was owned by two corporations and one individual. During and prior to the years at issue in this case (2012 through 2014), it had never declared and paid a dividend. For each year at issue, the taxpayer paid significant management fees, characterized as W-2 compensation, to each of its shareholders. The deduction of these management fees enabled the taxpayer to eliminate approximately 80% of its taxable income for these years. In addition, the individual shareholder, who was also the company’s president, received substantial salary and bonus payments, along with compensation for acting as a member of the company’s board of directors. The IRS examined the taxpayer’s 2012 through 2014 corporate tax returns and disallowed the management fee deductions, asserting that those payments should have been characterized as dividends because, with respect to the corporate shareholders, they were not paid for any identifiable services, and with respect to the individual shareholder, they were not reasonable. The IRS issued notices of deficiency asserting a total tax deficiency of almost $1.5 million plus penalties and interest, which the taxpayer contested by filing a Tax Court petition.

Law and Conclusion: Section 162(a) of the Internal Revenue Code allows taxpayers to deduct the ordinary costs of carrying on a trade or business, including, reasonable salaries or other compensation and similar payments to non-employees for services. Under related Treasury Regulations, whether a payment is deductible as compensation depends on whether the payment is reasonable (subject to certain exceptions) and is in fact a payment purely for services. In determining whether payment amounts are reasonable, Eighth Circuit courts (this case was governed by Eighth Circuit case law) look at several factors, including the employee's qualifications, the nature and extent of the employee's work, the size and complexities of the business, industry standards, a comparison of salaries paid to gross and net income, and to dividends paid, and general economic conditions, among other factors. In this case, the Court held that the management fees paid to the corporate shareholders were not for identifiable services because the taxpayer could not clearly identify anything more than minimal services provided to the taxpayer by its corporate shareholders. In addition, there was no contract between the taxpayer and those shareholders setting forth the services to be provided or establishing the amount to be paid for those services. Instead, the amount of the management fees were decided at a year-end board meeting, and the only rationale used to determine those amounts was how the taxpayer, as a whole, had performed; the payment amounts did not take into account the actual value of the services provided by the shareholders. With respect to the payments to the individual shareholder, the Court relied on expert testimony that, even before payment of the management fee, that shareholder, through the compensation he received as company president, was already paid $200,000 more than the average company president in the taxpayer’s industry. That being the case, the payment of the additional management fee for those same services was unreasonable. Accordingly, the Court found in favor of the IRS and upheld the notices of deficiency.

S CORPORATION REASONABLE SALARIES – Ward v. Commissioner, T.C. Memo 2021-32 (2021)

Why this Case is Important: Unlike C corporation shareholders, S corporations shareholders have an interest in paying themselves through profit distributions rather than W-2 compensation because of the way S corporations and their shareholders are taxed. As this case demonstrates, though, S corporation shareholders generally are required to receive a reasonable salary, and shareholders who do not collect a salary or collect an unreasonably low salary, while also receiving profit distributions, are at risk of having the IRS recharacterize those distributions as compensation.

Facts: In Ward, the taxpayer was an attorney and the sole shareholder and officer of her law firm. During the years at issue, 2011 through 2013, the taxpayer’s reporting of compensation paid to her by her law firm on the corporate and her personal tax returns was inconsistent. For each year, the company reported paying and deducted officer compensation, but on her personal return she reported these payments as non-taxable “draws.” The IRS examined these returns. Among other changes, the IRS determined that because the taxpayer was an officer of the company and provided services to the company, she was an employee of the company and all payments she received in exchange for her services were taxable compensation. Therefore, the IRS issued notices of deficiency to the company requiring it to pay employment taxes on the amounts paid to the taxpayer for each year and notices of deficiency to the taxpayer requiring her to pay income taxes on the same amounts (some or all of which would be paid through the company’s payment of the past-due income tax withholding). The taxpayer filed a Tax Court petition contesting these notices of deficiency.

Law and Analysis: Unlike C corporations, S corporations are not taxed on their taxable income. Instead, S corporations allocate their taxable income to their shareholders, who then report their share of that taxable income on their personal tax returns and pay income taxes (but not employment or self-employment taxes) on it. Because these income allocations are taxable regardless of whether the company actually distributes corresponding profits, S corporation profit distributions are not taxed. While W-2 compensation paid by S corporations is deductible, therefore reducing the taxable income allocable to shareholders, it is subject to federal and state employment taxes, generally making it more expensive for S corporation shareholders to pay themselves through W-2 compensation than through profit distributions. Under Sections 3212 and 3121 of the Internal Revenue Code, officers of a corporation who provide services to the corporation generally are employees of the corporation, and payments to employees for services generally must be treated as taxable compensation. This is especially the case for the sole shareholder of a corporation who is also an officer and provides services. Because the taxpayer was the corporation’s sole shareholder and an officer and provided services to the corporation, the Court found that the payments she received for those services constituted taxable compensation, rather than nontaxable draws, except to the extent she could prove that the payments were unreasonably high in relation to her services (in which case she could argue that at least a portion of the payments should be characterized as non-taxable profit distributions), or that they were never actually paid to her. The taxpayer could not prove either of these points, and the Court upheld the IRS’s determination.

If you would like more details about these cases, please contact me at 312-888-4113 or jnesser@lavellelaw.com.